Looking For Revenue In All The Wrong Places

As predicted from the Presidential campaign rhetoric, what to do with taxes has become the number one gating factor for solving the “Fiscal Cliff” challenge. As I outlined in my recent post “The Fiscal Cliff Is Built on a Mountain of Ignorance,” the debate is still hung up on the misperception that the Bush tax cuts reduced the Federal income tax burden of the wealthy. Republicans talk about revenues and the Democrats talk about rates. It seems like neither party knows of or cares about articulating the actual facts. After marginal tax rates were reduced in 2003, Federal income tax revenues increased sharply and the wealthy once again saw an increase in their share of the total Federal income tax burden. Those who continue to support raising marginal tax rates seem to be more concerned about how much of their income the wealthy get to keep rather than how much they send to Washington. Over the past 80 years, despite multiple movements in marginal rates up and down, the top 1% of earners paid an ever-increasing share of the total Federal income tax burden reaching its highest point at 40% after the Bush tax cuts and most recently representing 38.7% of total Federal income tax in 2009. Compare this to the total share of Federal income taxes paid by the 80% of tax payers who are in the 2nd through 5th quintile of earners who paid less than 6% of the total Federal income tax burden in 2009 (data from the Congressional Budget Office). How can any rational person who knows the facts interpret that 1% paying a total of 38.7% of the income taxes and 80% paying a total of 6% of the income taxes shows that the wealthy are not paying their fair share?

Unfortunately the debate on marginal tax rates isn’t the only uninformed debate. Another ill conceived target of the tax rate proponents is something called “carried interest.” Carried interest is not really interest. It is a payment made to managers of private equity and venture capital funds (as well as certain other funds). Managers of these funds raise money from what are called limited partners (pension funds, wealthy family offices, university and other not-for-profit endowments, etc.) and over a period of several years invest this money into privately held companies. After about 3-5 years (sometimes up to 10 years) if the private companies grow, they can be sold to larger companies or to larger private equity funds. In some cases, successful companies are able to go public, creating opportunities for all types of investors to own shares of stock in such companies (Genentech, Microsoft, Apple, Google, Wal-Mart, Home Depot and on and on). This entire process is a major economic and job-creating engine for this country.

Managers of these private equity and venture funds are compensated in two ways. First, they receive annual management fees, usually 2% of the total dollars committed to the fund by the limited partners. That 2% annual fee pays the salaries and overhead of the fund’s management. All salaries paid out of this management fee are taxed as ordinary income.

When a portfolio company of the fund is sold or goes public (usually several years after the fund makes its investment) at a profit to the investors, a distribution of cash (or stock if the company goes public) takes place. After the limited partners get back all their money that the fund invested in the company, the remaining profit is distributed 80% to the limited partners and 20% to the fund management. Thus, the managers only share in the profit made with the limited partners’ money. This is the “carried interest.” Currently, this carried interest is taxed as a capital gain. Some people assume that carried interest should be treated as salary and think it should be taxed as ordinary income. There is no logic for this. In essence, the fund managers are borrowing 20% of the total capital committed to the fund by the limited partners and are investing it alongside the 80% of the fund’s capital that generates the profit for the limited partners. Several years later, when the fund’s investments in certain companies are successful and there are profits to be distributed, the managers pay back the 20% of the capital they “borrowed” from the limited partners and keep the profit generated by that 20%. The managers, like the limited partners, are at full risk for all the investments made. No profit – no distributions. Just as the limited partners are taxed at capital gains rates on their profits so should the managers be taxed at the same rates. In other words, the longer than 1-year holding period, the return of 100% of the initial capital to the limited partners, and the full and equal risk that managers take alongside their limited partners (plus it is common for the managers to put some of their own money into the fund) all justify carried interest treatment as a capital gain. It is, in reality, no different from an investor borrowing money from a bank and making a successful investment in a company that is sold for a profit three years later. The investor pays back the bank loan plus interest (which is tax deductible) and pays capital gains on his/her profits. If the fund happens to lose money from its investments, management receives no distributions and the carried interest agreement does not allow management to share in the tax deductibility of the fund’s capital loss. More importantly, when funds don’t make money, managers are out of a job. If there is any logic in modifying the tax treatment of carried interest, the focus should not be on the profits generated but on the portion of the limited partner’s capital that is made available to the fund managers to generate their carried interest.

In the weeks after the election, we have heard from politicians and pundits and read in the editorials that the voters spoke in the election and supported raising taxes on the wealthy. But what do you expect when the voters have been immersed in totally misleading and non-fact-based rhetoric about who pays what in taxes and what actually happened to the distribution of income tax payments after the Bush tax cuts? The Bush tax cuts have been described as a tax break for the wealthy. When is paying both more and a greater share of the total income tax burden a tax break? The poll that needs to be taken is the poll that asks the voters (and for that matter the talking heads and the press) three questions: (1) What was happening to Federal income tax revenues in the three years before the Bush tax cuts and what happened after the cuts? (2) What happened to the top 1% of earner’s tax bill after the Bush tax cuts (not what income did they keep but what happened to the size of the check they sent to Washington)? (3) What happened to the top 1% of earner’s share of the total Federal income tax burden after the Bush tax cuts? My prediction is that, over 90% of voters would get none or at best one of these answers correct. Even worse, the large majority of members of Congress, the talking heads, and the press would do no better--an astounding and unfortunate level of ignorance.

Despite the fact that the wealthy pay much more than their fair share in taxes, most wealthy are willing to support good causes, including legitimate revenue needs of our government – not because they feel rightly accused of not paying their fair share, but because as a group they are thankful for their success and respond with generosity.

Mounting a campaign to somehow marshal the majority of voters to think that the wealthy don’t carry their fair share is inappropriate and unnecessary. What the wealthy (and so many others) see is enormous government waste and inefficiency. What they see are tax proposals that pose risk to a fragile economy. What they see is politically and ideologically driven rhetoric- not great ideas. Norman Vincent Peale had it right when he said “Once we roared like lions for liberty. Now we bleat like sheep for security. The solution for America’s problem is not in terms of big government, but it is in big men (women) over whom nobody stands in control but God. ” That was 20 years ago. It’s time for the big men and women to step up.